House Prices Finally Approaching Fair Value...

As goes housing, so goes the rest of the economy. So where
do things stand? After two years of precipitous declines
that have taken prices down almost 30% from the peak, house
prices are finally approaching fair value (which is perhaps 10%
below today's level).

That doesn't mean that house prices will only fall another 10%,
however. On the contrary, given the tendency for prices to
overshoot, it would be startling if house prices stopped at fair
value. More likely, they'll drop at least 10%
below fair value before they finally trough.
Although the rate of decline is likely to ease over the coming
months and years, therefore, prices will likely keep falling through at
least 2011. And there's at least 20%
downside left.

Below, a review of the most revelant data:

First, the big
picture. Here is how house prices have
behaved over the past 120 years, adjusted for inflation, courtesy
of professor Robert
Shiller. The house price line is on top. Prices
are indexed against the 1890 price (left scale), and the chart is
updated through the end of Q4. This analysis suggests
prices still have to fall about 10%-20% just to get back to fair
value:

Here's the same chart superimposed on the economy
by the New York Times. A Barry Ritholtz reader has
updated it to reflect the projected decline. Importantly,
this version is a couple of quarters out of date. The
latest value (end of Q4 2008), as calculated by Professor
Shiller, is 137%, not the 155% shown in the chart. Prices
have kept dropping since December, moreover, so the actual
current value is probably closer to 130%.

Given the modest long-term upward slope of this chart, fair value
is probably somewhere in the 110%-120% range (again, indexed
against 1890, adjusted for inflation). So this suggest
we're still about 10% above fair value. However, note what
happened to prices from 1910 to 1940.

"Housing P/E" measures graph house prices against rents and
incomes. These are the closest thing we have to a
price-earnings ratio for housing.

Both measures show that prices are still high but are finally closing
in on average levels. After a bubble like
this, we would expect prices to significantly overshoot.
But the absolute values are finally beginning to look
encouraging.

Bear in mind that, as with corporate earnings, rent and incomes
are cyclical: As the economy deteriorates, rental rates will drop
(as they are now). The same goes for incomes. All
else being equal, this will make house prices look more expensive
than on these charts.

Price to rent (source
Northern Trust) is closing in on fair value. Note that the date lines in the chart below are
one standard deviation ABOVE fair value for the periods in
question. The mean for 1987-2008, which
includes the bubble, is 110%, which is about where we are
now. The mean excluding the bubble, however, is another
10%+ below today's level.

Price To Income (source:
Calculated Risk) Closing In On Fair
Value. The
trough value for the previous housing decline was 10%-20% below
today's level.

Housing Affordability Index at record
high...but not particularly
meaningful

The National Association of REALTORS and other housing promoters
now point to the "Housing Affordability Index" as a measure to
suggest that houses are already undervalued. Thanks to low
interest rates, this theory goes, houses are more affordable--so
prices will soon start rising again.

The NAR's latest "housing affordability" calculations are
below. But before you get excited, recall the NAR's track
record (In 2007, the NAR said house prices would keep right on
rising despite the levels in the charts above because houses are
always a great investment and that house prices never go down).

Also recall two things: First, the NAR's housing "affordability"
index does not take into account the tighter lending standards
that most banks have implemented in the past two years (making it
harder for would-be buyers to get loans). Second, just
because you can theoretically "afford" a house based on your
income doesn't mean that you can go out and buy one.
Imagine, for example, all the homeowners who would love to buy a
house that's much cheaper than the one they have but can't
because they can't sell their own house.

In any event, here's the NAR's Housing Affordability Index
through Feb. See the third column from the right:

Inventories are still too
high and will continue to put pressure on prices.

Contrary to what your real-estate agent told you three years ago,
house prices are subject to the law of supply and demand.
Thanks to our construction frenzy of two years ago, today's
tighter credit standards, and our ongoing refusal to let in more
immigrants, there's still a lot more supply of houses than demand
for them. This situation will continue to put pressure on
house prices until inventories approach normal levels.

As these
charts from Calculated Risk show, absolute inventories of new
and existing houses for sale have declined in recent
months. This is good news. The drop in new houses in
particular is back to the trend level (but not below it).

Alas, inventories aren't everything. The pace of sales has
slowed, so declines in inventory have almost been matched by
reduced sales velocity. There was an uptick in sales
velocity in February, which everyone got excited about, but it's
important to put this uptick in a long-term context:

The reduced sales velocity means that the number of months it
will take to work through the existing house inventory is still
well above normal. For existing houses, for example, we now
have 10 months of inventory, versus the 4-5 months that would be
more normal:

The bottom line

Thanks to the precipitous declines of the past two years, house
prices are finally approaching fair value. But they likely still
have another 20% or so to fall (nationally), and they will likely
continue to fall for at least two more years.